–The “impossible” cure for stagflation

The debt hawks are to economics as the creationists are to biology.

Stagflation is economic stagnation or high unemployment combined with high inflation. Here is what a Wikipedia author said. “It is a difficult economic condition for a country, as both inflation and economic stagnation occur simultaneously and no macroeconomic policy can address both of these problems at the same time

This is one statement with which, both mainstream economists and Modern Monetary Theorists (MMT) seem to agree. I disagree with both.

Economic stagnation, high unemployment and recession all indicate the same fundamental problem: The economy is starved for money. Inflation (wrongly) is felt to be caused by too much money, which is why we experience the universal belief that “no macroeconomic policy can address both of these problems at the same time.”

Stagflation is most likely to occur when oil prices spike. A rapid increase in oil prices causes inflation. It also has a negative effect on production and economic growth. U.S. stagflation could occur, even in the near future, were any major oil producing states, for economic or political reasons, decide to reduce production dramatically.

Debt hawks (aka mainstream economists) would address stagflation with increased federal spending, while simultaneously increasing taxes to “pay for” the spending. The benefits of the increased spending would be offset by the damages of increased taxation. The former adds money to the economy; the later removes money from the economy — equal and opposite effects.

Even today, as we try to recover from the worst recession in decades, debt hawks continue to demand increased taxes to “pay for” spending, not realizing that in a monetarily sovereign nation, taxes do not pay for spending. Simultaneously, the Fed, wrongly believing interest rate cuts stimulate the economy, would lower rates, thereby exacerbating the inflation.

The Fed believes this, because raising interest rates does cure inflation, and for reasons known only to the Fed, they believe inflation is the opposite of recession, so for recessions, they do the opposite. Unfortunately for Fed theorists and for us citizens, the opposite of inflation is deflation, not recession, so doing the opposite doesn’t work.

MMT followers also would increase spending (good) and increase taxes (bad), because they believe taxes control inflation.

In short, MMT and debt hawk economists would follow the same path, an irony lost on both groups, each of which correctly claims the other does not understand current economics.

To cure stagflation, one must deal with two distinct problems – recession and inflation – using two distinct solutions. The solution for recession is federal deficit spending. Money is the lifeblood of an economy. During a recession, an economy suffers from “anemia,” a shortage of money. The treatment for anemia is to increase the blood supply. The government’s deficit spending adds money to the economy, curing the stagnation. Deficit spending can be accomplished by cutting taxes, increasing spending or both.

Then, to cure the inflationary part of stagflation, the government must raise interest rates, thereby increasing the reward for owning money, i.e increasing the value of money.

Increase deficit spending while increasing interest rates: The simple solution for taxation. Why will the government not take these easily administered steps? Because the mainstream economists wrongly belief deficit spending causes inflation, while MMT wrongly believes tax increases control inflation, and the Fed wrongly believes raising interest rates slows the economy.

Until these three groups understand economic realities, please pray we don’t encounter a stagflation, because the government will find it incurable.

Summary of how each group would attempt to defeat stagflation:

Mainstream economics (debt hawks):
Reduce taxes to stimulate economy
Reduce federal spending to cut federal debt
Increase interest rates to fight inflation
(Result: Reduction in federal spending nullifies tax reduction and exacerbates recession)

Modern Monetary Theory:
Increase taxes to fight inflation
Increase spending to stimulate economy
Reduce interest rates to fight inflation
(Result: Tax increase nullifies spending increase and exacerbates recession. Reduced interest rates exacerbate inflation)

Reduce taxes to stimulate economy
Increase spending to stimulate economy
Increase interest rates to fight inflation
(Result: Tax reduction & spending increase cure recession; interest rate increase cures inflation)

Rodger Malcolm Mitchell

No nation can tax itself into prosperity

36 thoughts on “–The “impossible” cure for stagflation

  1. Do monetarily sovereign countries have the right to print as much money as possible with no monitoring? Isn’t that the reason why Zimbabwe is in the situation it is in currently?


  2. Roshan,

    See: Monetary Sovereignty for the answer to your first question.

    Historically, hyperinflation has been caused by economic circumstances unique to each country. These circumstances cause inflation, which the country attempts to deal with by printing money. In short, the inflation causes the money printing, and not the other way around.

    Zimbabwe’s problems came from land confiscation, droughts, reduced exports, government price controls and most of all, criminal behavior by Robert Mugabe.

    In America, the greatest inflation of the past 45 years came in 1979 (Carter administration), during a time of modest federal deficits. The inflation was cured during the Reagan administration’s massive deficit spending.

    Historically, inflation has been caused by energy prices. (See: INFLATION )


  3. Ignorance, I suppose. They don’t know what else to do, so as prices rise, they simply print more money to pay for things. Then prices rise even more, in an upward spiral.

    Some governments have tried to attack inflation by legislating prices (aka price controls), which only exacerbates inflation, because it does not deal with the fundamental problem: Money’s loss of comparative value. It’s like giving an anti-biotic for a viral infection. It makes things worse.

    To attack inflation requires increasing the value of money, which in turn, requires increasing the reward for owning money, i.e interest.

    Rodger Malcolm Mitchell


  4. It seems to me you are misrepresenting MMT. They are perfectly clear that spending and taxes work the opposite way. Nobody there would describe theseoffseting actions as having any real impact.


  5. Possible misunderstanding. Yes, federal spending and federal taxes work the opposite way. No disagreement. Where I disagree with “MMTers” is in their belief that inflation should be prevented and cured by raising taxes. While this probably would reduce inflation, it is too slow, too political and too imprecise to be a useful tool. Further, by removing money from the economy, tax increases hurt the economy. I don’t think exchanging inflation for a recession is a good trade-off.

    If we had, for instance a 5% inflation today, imagine trying to pass a tax increase of the right size and on the right people, to reduce that inflation to say, 3%. Totally impractical.

    I suggest inflation can be addressed by raising interest rates, which increases the reward for owning money, thus making money more valuable. Interest rates can be moved quickly and in tiny increments, and do not require tedious passage through Congress.

    MMT believes raising interest rates actually exacerbates inflation, by making business costs higher. History shows this view is incorrect. I have discussed this at length with Warren Mosler and Randy Wray, whose sites you can access when you wish.

    Other than the method to deal with inflation, I pretty much am in the MMT camp.


  6. How could raising a sales tax, or a land value tax be any slower at eliminating transactions than raising interest rates?

    A sales tax increase eliminates transactions near instantly – as we’re about to find out in the UK when they put VAT up.

    Taxation eliminates money permanently, where as raising interest rates simply moves money from borrowers to savers. Borrowers are deprived of a flow of money which is transferred to a stock of money in the hands of the savers.

    So you are redistributing from those with a propensity to spend to those with a propensity to save.

    Saving appears to me to be monetarily equivalent to taxation that is reversible at the will of the individual, rather than the state.

    So as far as I can see increased net-saving is just a ‘privatised’ version of taxation. Both stymie flows of money.


  7. Neil,

    Changing tax rates requires Congressional debate about which tax to raise and how much and whether that particular increase will affect some Congressperson’s favorite industry. Then there will be a vote in the House and a vote in the Senate, both marked by political infighting and posturing. Finally, after House/Senate reconciling, the bill will go to the President who may or may not veto it.

    Note how long it has taken Congress to decide whether to extend some or all of the Bush tax rates.

    By contrast, the Fed can raise interest rates instantly, as it chooses.

    You are correct that taxation eliminates money permanently, which has been shown to lead to every depression and most recessions in our history. See: https://rodgermmitchell.wordpress.com/2009/09/07/introduction/

    Saving does not destroy money as taxation does. Saving merely transfers money from the saver’s hands to the saving institution’s hands, whereupon it continues to be transferred again and again.

    Rodger Malcolm Mitchell


    1. Savings institutions don’t work like that though. There is no rule that states the money will be transferred over and over. That depends on the demand for money.

      Savings are just liquidity – there has to be a supply of borrowers willing to pay the price of the money (and sufficient bank capital on which to make the loan) to make use of that liquidity or it simply sits in the Federal Reserve earning the overnight rate.

      Just as a very large amount of the stuff is at the moment.

      Raising interest rates would surely mean (in more normal times) that the number of borrowing transactions would decrease and reserves would build up. ie you’d start to get net-saving in the non-government sector.


      1. You made a flat statement: “Saving appears to me to be monetarily equivalent to taxation that is reversible at the will of the individual, rather than the state.” That statement is not correct.

        Taxation always destroys money. Period. It never is “reversible.”

        While some savings may be used to purchase T-securities, much is not. Further, while taxation represents a 100%, permanent loss to the taxed, any savings invested in T-securities merely represents an exchange of more liquid money for less liquid money — huge difference.

        Are you aware that T-bills are money? They once were classified as “L” (M3 + longer term securities). See: http://www.investorwords.com/2704/L.html

        Rodger Malcolm Mitchell


  8. Neil,

    Really? Delegate which taxes to raise and by how much? So, if (for instance) someone felt like raising FICA a few points, and maybe raising taxes on the poor a few more point, the nation would simply go along with it?

    That’s neither real nor smart. You’re bringing unreality into your argument.

    Rodger Malcolm Mitchell


  9. I’m sorry Rodger. I didn’t mean to be rude. I’m just trying to understand whether you have an genuine economic effect or not.

    I can understand the pragmatism because of the general distaste of taxes. Having said that if the right can push austerity at the moment then frankly you can sell anything given the right spin and enough airtime.

    I also appreciate your psychological anchor on taxes – you’ve written a book and you will be fixed to a position. I’m not trying to change that – just understand if there is anything real there.

    So given that, if Congress delegated to the Treasury the ability to raise a tax levy on borrowing by a given percent of the borrowing as long as they then spent the same percentage as a bonus to savers, how is the fact that you are doing it via the spend and tax route different from simply raising interest rates?

    Is there an economic effect, or is it purely psychological?


  10. I don’t have a “psychological anchor” (whatever that is) on taxes. In a monetarily sovereign nation, there is no relationship between federal taxes and federal spending. None. So if taxes were $0, this would not affect by even one penny, the government’s ability to spend.

    This is not an opinion or a “psychological anchor”; it is a simple, undebatable fact regarding monetary sovereignty. It is part of the definition of monetary sovereignty.

    By the way, your country, the U.K. is monetarily sovereign, too. As with the U.S., the U.K.’s leaders are hell-bent on destroying that nation with their “austerity” programs.

    The irony is, the U.K. was smart enough not to adopt the euro, thereby retaining its monetary sovereignty, but seemingly has forgotten why.

    Rodger Malcolm Mitchell


  11. The UK is about to be run into the ground for sure. The debate here is puerile at best. It’s all very depressing.

    I appreciate that there is no funding requirement, or particular relationship between spending and taxes. However according to MMT they function together to regulate the amount of transactional activity in the economy.

    Too much transactional activity and you will get price inflation.

    If a government spends $100 and there are no taxes then that $100 will bounce around the economy forever creating lots of transactions and never disappearing.

    Any positive tax rate would make sure that $100 had a finite lifetime before it is ‘drained’ from the economy.

    In your view how do you regulate the number of transactions the constant government spending will induce. What is the mechanism that ensures the number of transactions doesn’t exceed the economy’s capacity to deliver so that it doesn’t resort to its default option – raise prices.

    What is it about your interest idea that creates the necessary ‘drag’ on transaction numbers?

    Like I said I’m trying to understand if there is an economic effect you have captured that is not described elsewhere.


  12. Yes, I argue with Warren Mosler and Randy Wray about this all the time. So far, they seem to be without actual evidence of their position.

    A growing economy requires a growing per capita supply of money. Even a stagnant economy requires a growing per capita supply of money, just to overcome annual inflation.

    There is a point at which money creation could cause inflation. We are nowhere near that point, as witness the current fears about deflation, despite massive money creation.

    In 1971, Federal Debt Held by Private Investors was $225 billion. Today it is $7.9 trillion — and astounding 3,500% increase in only 40 years! What would you have said in 1971, if I told you the debt would increase 3,500% by 2011? You would have predicted rampant inflation. Right?

    So now, if I predict the debt will grow another 3,500% by 2051, what do you predict?

    In fact, since we went off the gold standard in 1971, there has been no relationship between federal deficits and Inflation.

    Do not be fooled by what happened in pre-war Germany, Zimbabwe, Italy, China and all the other nations that suffered from hyperinflation. Each had unique circumstances, not related to the U.S. condition.

    It gets down to: What is inflation? It is the loss in value of money, compared with the perceived value of goods and services. The cure is to increase the value of money.

    You can increase the value of money either by reducing the supply (taxes) or by increasing the demand (interest). History shows that reducing the supply causes recessions and depressions, while there is zero relationship between high interest rates and slow GDP growth.

    So which approach do you favor? Reducing the supply or increasing the demand?

    Rodger Malcolm Mitchell


  13. I’m very late to this thread; came across it in a search on MMT and stagflation.

    I’d like to note that (it appears to me that) MMTers are significantly constrained in how high they can allow short term interest rates to be. Their policy prescriptions tend to lead to very large deficit stocks which take the form of either very large excess reserves, or large stocks of State debt issued to drain those reserves to give the central bank control, via open market operations, over short term interest rates (which fall to zero if there are too many excess reserves).

    Hiking short term interest rates by the central bank while simultaneously maintaining and rolling a large stock of short-term state debt (MMTers tend to think that long-term debt is not needed) could (it appears to me) lead to a spiral in which the state deficit (and the debt issued to drain the new reserves to maintain CB control over short-term rates) must significantly rise simply to pay the interest on the short term debt. (One could avoid this interest by retiring the debt and maintaining the deficit stock as CB reserves, but then the CB would lose control over short term interest rates.) If inflation is not quickly brought under control, it seems to me that this could lead to an unhealthy situation in which the short term debt (or equivalently, the stock of excess reserves at the CB) becomes increasingly and perhaps arbitrarily large in terms of the economy.

    I suspect that it is for reasons like this that MMTers prefer to use taxation to control inflation by dampening demand. I think that they prefer that the short-term rate be kept very low — I think that this is to avoid the spiral mentioned above. I do think that you are right in asserting that this gives them only one policy tool (the public sector deficit) with which to pursue the two goals of full employment and low inflation.

    I’m not familiar with your alternative to MMT, but I wonder whether it might be vulnerable to the same problem. If the stock of public deficits gets very large, it might be hard to pay enough interest on it to dampen inflation. Or is there a way to set short term interest rates other than open market operations by the CB?


  14. Samuel,

    Monetary Sovereignty (MS) holds that,

    1. Federal debt (i.e. the issuance of T-securities), whether short term or long term, is unnecessary. Eliminate T-securities and you eliminate federal debt and federal interest.

    2. The Fed sets the Fed Funds rate, which essentially sets the bottom rate for interest.

    3.If the Fed Funds rate alone does not control interest, the Treasury always has the power to issue T-securities in any amount, regardless of federal deficit spending. Functionally, there can be deficits without debt, and there can be debt without deficits. So the government has complete control over the amount of debt and interest rates.

    4. Open market operations do not really set interest rates. The Fed sets short term rates by fiat, and the market follows.

    5. Money is a commodity, the value of which is determined by supply and demand. Demand is determined by risk (inflation) and reward (interest). So to control the value of money (inflation), we must control supply and interest rates. (The value of money also is related to the value of goods and services, but that is a separate issue.)

    MS disagrees with MMT about reducing spending to control inflation, as spending reductions historically have lead to recessions, while interest increases do not. (See: https://rodgermmitchell.wordpress.com/2009/09/09/low-interest-rates-do-not-help-the-economy/) MS believes the MMS approach also can lead to stagflations, which MS can cure, but MMT cannot.

    Rodger Malcolm MItchell


    1. I believe that MMT argues that the Central Bank should pay interest on reserves at the target short term rate and then dispense altogether with open market operations, and indeed with sovereign debt at all. Just leave all the deficit stock as reserve balances at the CB. But this does seem to create a potential for a spiral if the CB raises the short term interest rate target to fight inflation. If there is a positive short-term interest rate target, the reserves will grow exponentially on a time scale determined by the target rate. At least some MMT people seem to prefer that the target rate be zero (perhaps for this reason).

      If the deficit stock, and the corresponding bank reserves at the CB, is large (and over time in MMT and presumably MS policy, it will become large, perhaps multiples of GDP) and if the interest rate is hiked to control inflation, then the interest paid on the excess reserves will be large, and the reserves will grow exponentially with a shorter timescale, until the policy rate is reduced.

      It seems to me that this could lead to a spiral in which the reserves at the CB grow much more rapidly than the “real” economy, and I wonder whether there is a limit on how large that ratio could safely become in either MMT or MS. Suppose that the deficit stock is 300% of GDP, all of which is in reserves at the CB, and suppose that, to fight inflation, the policy rate is set at 5%. This will result in reserves growing by 15% of GDP the first year of such policy, not including the effects of additional public deficits. Is there no limit on how large the deficit stock can safely get?


  15. Good comments, Samuel.

    They touch on the question: What is the purpose of bank reserves?
    1. We no longer are on a gold standard.
    2. FDIC protects depositors.
    3. Reserves are available to any bank in unlimited amounts.
    4. Bank lending is limited by bank capital, not by reserves.

    Any thoughts?

    Rodger Malcolm Mitchell


    1. Hi Rodger,

      According to MMT people, as I understand it, bank reserves facilitate the payments system. That’s uncontroversial. According to the functional finance component of MMT, which as I understand it is purely descriptive and so also ought to be uncontroversial, governments spend by creating reserves which are credited to the banks at which the recipients of the spending have their bank accounts. Taxation reduces reserves and also withdraws demand from the real economy. The Federal Reserve Bank typically manages the level of reserves and controls the short term interest rate through open market operations (though it doesn’t have to do it this way; it could pay a support interest rate on excess reserves and, if the support rate were the same as the policy rate, could set the short term rate by this means without OMO. I believe that this is the preferred method for MMT, and I have the impression that they tend to favor very low policy rates, even zero).

      Again within the functional finance component of MMT, the issuance of public debt serves two purposes (neither of which is related to funding government spending; a point I’m sure you have made), to give savers who want to hold safe debt some return on their savings and to drain excess reserves out of the banking system. If the level of reserves is too high, the interbank lending rate will fall to the CB support rate, and if this is lower than the target short term policy rate, the CB will not be able to enforce its desired policy rate. My impression is that MMT advocates tend to prefer a CB policy of zero interest on reserves anyway; they appear to relinquish CB influence on short term interest rates as a policy tool.

      How large a multiple of GDP could reserves get without causing trouble? I don’t know. Given that, as you say, bank lending is capital constrained, perhaps there is not a strong mechanism or channel by which a huge reserves balance could destabilize an economy. Certainly the large scale asset purchases by the Fed in recent years, which injected a lot of excess reserves into the banking system, have not led promptly to inflation. But it seems to me that one ought not to regard
      placidly the prospect of reserve balances becoming arbitrarily large. Reserves in a bank’s account at the Fed are an asset, and it seems to me that they could be swapped for other assets, and this might result in asset price bubbles. Certainly that is true of Treasuries. MMT people make much of what they assert is a very similar character of reserves and sovereign debt; one is like a demand deposit account and the other like a time deposit account. Treasuries can be traded or repo’d and the proceeds used to purchase real assets. To have an arbitrarily large amount of sovereign debt circulating in an economy would seem to be inflationary. Is something similar true of reserve balances? If not, this is a way in which the MMT analogy between reserves and sovereign debt breaks down, but in a way that favors MMT, which prefers to not issue debt except as a courtesy to savers). If reserves can’t be swapped for other assets, then they are less inflationary than sovereign debt, since that can be swapped for real assets.

      And if there is absolutely no way for reserve balances to leak into the real economy other than capital constrained bank lending, then yes, I would agree that you could pay any interest on them you like without fear, and that should give the CB control over short term rates and influence over liquidity preference.

      Are there no channels other than capital-constrained bank lending by which reserves can influence the real economy? I don’t know.


    2. Hi Rodger,

      One further thought and amendment of my prior response. Granting for the sake of argument (and perhaps it’s true) that there is absolutely no way for reserves to “reach” the real economy, I’m moved to wonder, “why then, do banks care about their reserve balances?”. At the present time, banks plainly do care about their reserve balances. They try very hard to increase them by earning interest on them in the interbank overnight lending market. At the present time, reserves can be converted into short-term sovereign debt which can be used as collateral for borrowing, or which can be traded and the proceeds used for other profitable activities.

      What would happen if one stopped issuing sovereign debt and allowed the quantity of reserves in the banking system to get arbitrarily large? One consequence that seems certain is that most banks would no longer need to borrow in the overnight interbank market. They would already have more than enough reserves to meet their payments needs.
      I don’t understand MMT well enough to know, but it might be that this is part of the justification for abolishing a support rate — when the level of reserves becomes a lot larger than the amount of economic activity that the banking system serves, when every bank has more reserves than it knows what to do with, and they can’t do anything with them because there is no sovereign debt market, there doesn’t seem to be much point in rewarding them for holding reserves. If there is an effectively infinite (by “effectively infinite”, I mean, “much larger than required for the needs of the payments system”) amount of reserves in the banking system, and no way to use them profitably in the real economy, there is zero value in marginal growth of reserves.

      It seems to me that in such a situation, the CB support rate paid on reserves might no longer control the short-term interest rate in the real economy. The support rate is a floor to the interbank lending rate, but in a system with effectively infinite reserves, there would not be much interbank lending, would there? It’s not clear to me in this situation what the transmission channel of the support rate to lending rates in the real economy would be. It might be that the CB would lose control of short term rates in any event, which might be part of why MMT tends to prefer a policy rate of zero.


  16. Samuel,

    “. . . why then, do banks care about their reserve balances?” The law requires this, though reserves easily are available to any bank.

    So, should the law require reserves? I think not.

    Consider an overly simplified example of the flow of “money,” which more properly should be called the flow of instructions. When someone pays you by giving you a check, that check is not money. It is instructions to your bank to increase the numbers in your checking account.

    The instructions then go to the Federal Reserve Bank for clearing. The FRB forwards the instructions to the payer’s, telling that bank to reduce the numbers in the payer’s checking account. No money has moved. Per instructions, one account is marked up and one is marked down.

    Functionally, the FRB acts like a commodity clearing house, simply marking up and marking down accounts. I do not understand the post-1971 need for reserves, either for local banks or for the FRB bank.

    The Treasury, has the unlimited ability to insure all bank accounts from bank failure — including the FRB’s — merely by marking up accounts. Borrowing one of Warren Mosler’s favorite analogies, what reserves does a basketball scoreboard need?

    I suggest that reserves are a relic of the gold standard days, and I am surprised MMT does not seem to recognize this. Or perhaps they do, and simply are working within the confines of existing law.

    Rodger Malcolm Mitchell


  17. Samuel,

    i just spoke with Warren Mosler (MMT), telling him, “My belief is in this post-1971 world, bank reserves are unnecessary.” I asked his opinion.

    His response was, “Canada has no reserve requirements and it works better that way.”

    Rodger Malcolm Mitchell


    1. Hi Rodger,

      I suppose that one could do away with the reserves system entirely, but then one would need another way to transact interbank payments. I don’t think you are advocating that. But without a system of this kind, how would governments spend? At present, according to MMT (and I think you agree), governments spend by creating balances at the Central Bank and crediting them to the CB accounts of the financial institutions at which the spending targets have their deposit accounts. Governments could also spend by printing currency and depositing that, but that seems like a waste of effort and paper. MMT (I think) doesn’t like that idea because the creation of large amounts of circulating currency (over time, perhaps up to multiples of GDP) does seem to be inflationary. Perhaps I’m mistaken, but to put vast amounts of government debt into circulation (currency being an IOU of the state, redeemable against tax obligations, per MMT) would seem to make asset price bubbles or inflation likely. If the money is locked up in bank reserves at the CB, it is relatively inert. But as circulating cash, it certainly could be used to bid up prices.

      If I understand MMT (and I recognize that I don’t fully), reserve requirements don’t do what the mainstream thinks they do — reserves don’t constrain bank lending. You agree. According to MMT, they simply lubricate interbank payments, precisely as you have described. Could one do interbank payments without them altogether (with zero net reserves in the banking system)? I suppose so, but one would still require that the banks not go into arbitrarily large deficit after all payments (or instructions, as you say) have been made within some accounting period. So even if you don’t call them reserves, there is still a reserve requirement in that banks have to not overdraw their spreadsheet entries at the Central Bank beyond a certain finite amount (zero, at present). That would be a “non negative reserves balance” requirement, or a “no more negative than thus and so reserves balance” requirement. So I don’t think it is a matter of not having reserves, but simply what level one thinks is adequate to lubricate payments. Perhaps zero is adequate. But then there would be interbank borrowing (or borrowing from the CB; as you say, banks can get whatever reserves they need, though some price). I don’t think that one can simply do away with any reserve requirement at all and permit arbitrarily large bank overdrafts at the CB. And if one did, that would certainly be the end of interbank lending of reserves and the end of the relevance of the CB’s short term interbank lending interest rate target.

      But to take your analogy further, the government spends by sending instructions. These instructions (or the effects of the implementation of the instructions) accumulate at the Central Bank, or “the cumulative sum of the spreadsheet entries in the reserve accounts” of the banks accumulate at the Fed. They can only (at present) be extinguished by taxation or by draining them through bond sales by the CB. They could also be reduced by converting them into issued currency, but that does seem to be inflationary. So whether you call them reserves or instructions or spreadsheet entries, they are there at the CB and they accumulate as the government deficit spends (and I’m not saying this to criticize deficit spending; I’m persuaded by MMT accounting arguments that we need deficit spending for the private sector to accumulate net financial assets, which is presumably a desirable thing). Further, in the absence of sovereign debt outstanding and Open Market Operations by the CB, the short term interest rate is set by the CB through the support rate it pays on reserves/instructions effects/spreadsheet entries balances. I don’t think that changing the name changes my concern. If these become so large that there is virtually no interbank lending, I think that the CB loses its ability to set short term rates in the real economy. It might declare that it wants short term rates to be thus-and-so, but how would it impose that? At present, it imposes that through Open Market Operations and/or through the support rate it pays on bank balances of whatever you want to call them at the CB. What is the alternative mechanism by which the CB could decree and enforce its desired short term policy rate? So it’s not clear to me that, in a world in which governments do not drain bank balances at the CB through the issuance of debt, the CB has effective control over short term rates. And I suspect that may be why MMT people tend to favor very low CB policy rates and a low or zero support rate.

      And if that is true, then raising short term interest rates may not be possible in a MMT/MS regime (if the level of spreadsheet entries at the CB is so large that there is no need for interbank lending, or if one does away with reserve requirements altogether and allows banks to limitlessly overdraw at the CB) and there may be no way at all for monetary policy to reduce inflation in a stagflationary episode. I don’t think that this troubles MMT. They seem to regard stagflation to be the result of demand-side price inflation of limited availability commodities (oil, in the ’70s era stagflation, for example). Eventually it works its way out as the rising price level of the undersupplied commodity stimulates substitutions or consumption efficiencies. Governments could promote such substitution and efficiency by deficit funding research.

      I do fully agree with your view that MMT cannot tame both inflation and unemployment in a stagflation through the use of fiscal policy alone. They have only one tool and two problems to solve. But I think that in the MMT approach to government “finances”, which I think you approve, it may in fact not be possible for the Central Bank to control the short term interest rate, for the above mentioned reasons. In the absence of interbank lending and with “reserves” so large and inert that the banks don’t have any reason to want more of them, or with reserves utterly irrelevant, the Central Bank’s policy tools don’t seem to have a transmission mechanism to the real economy. I’d like to be mistaken about that, since two policy tools would be better to have than only one.

      What, functionally speaking, would the Central Bank do in a MS policy regime to set short term interest rates?


  18. “What, functionally speaking, would the Central Bank do in a MS policy regime to set short term interest rates?”

    How about a federal money market? How about setting, by law, bank loan interest rates? How about direct federal lending to the private sector? How about getting rid of private banks altogether?


    1. Hi Rodger,

      That might work. I’ll have to read more about MS. At my present level of incomprehension, If you had righteous technocrats running the banks for public weal rather than for private profit, then even the present system could be made to work for public benefit. Thanks for bearing with me.


    2. Hi Roger,

      The thought that I aborted in the prior reply was “At my present level of incomprehension, I don’t feel optimistic about any policy regime.”


  19. Hi Rodger,

    Suffer me to think out loud about the idea of abolishing the private banks and the assumption of all present banking functions by the central government.

    For the sake of my own clarity and to provide me with a model to think about, I’ll suppose that the CB becomes “everyman’s bank”. Now, instead of banks having reserve accounts with the CB, and non-bank private sector actors having accounts with the banks, all private sector actors have their accounts with the CB, and central governments spend by crediting the accounts of the private sector entities from whom it wishes to purchase goods and services, or to whom it wishes to make transfers. For the purposes of this discussion, by “private sector” I mean “non central government”, so I am including lower levels of government in the “private” sector. My distinction is between currency issuers and non-issuers.

    There’s only one bank, controlled by the central government. There are no other lenders (or private lending of money at interest rates lower than the rate set by the CB could be made a crime, if one wished).

    The CB takes care of all payments clearing by directly crediting and debiting its private sector account-holders’ accounts.

    I’m going to keep the MMT language of deficit stocks and flows as this is useful.

    Every year, the central government deficit spends enough to ensure full employment and the CB sets the interest rate high enough to keep inflation low (how high that would have to be, given a specific set of economic facts, I am not skilled enough to estimate).

    The public deficit stock, which in MMT is locked up in the inert form of reserves, is sitting in the CB accounts of the private sector actors. Each year, the annual deficit flows first land in the accounts of a subset of the actors, but then they spend it and it spreads throughout the rest of the economy, which is to say into some issued currency and the rest as CB account balances of all the private sector actors. Assuming no external transfers and no significant conversion to paper currency, the cumulative balances of all accountholders at the CB grows every year by the amount of the public deficit. Unlike the relatively inert bank excess reserves in MMT, which cannot be spent, these account balances are all spendable. They have to be since otherwise central government spending would not reach the economy.

    This looks highly inflationary to me. To take a plausible MMT fiscal scenario (and I think that the numbers would be reasonable for MS
    since the fiscal principles are similar), suppose that a 10% public deficit
    yields full employment with 4% real GDP growth. Over time, the public
    deficit stock will rise to 250% of GDP. All of this deficit stock exists as
    spendable account balances of private sector actors.

    In present US terms, that would be like having of order $37 Trillion
    of spendable account balances in the possession of the private sector.

    How high would one have to set interest rates to prevent inflation in such a case? My non-economist intuition is that they would have to be set very high, so high that it would shut down nearly all borrowing. On the other hand, with such vast amounts of money in the private sector account balances, maybe there would not need to be much borrowing. Certainly many private sector actors would be able to finance working capital requirements out of their CB account balances. (It appears to me that this corresponds exactly to the MMT situation in which high excess reserves eliminates the need for interbank borrowing)

    Would the CB pay this interest to its depositors, or merely charge it to borrowers? If it didn’t pay it to depositors, then the high rate policy would not make it desirable to hold cash and would not accomplish the intent of incentivizing the holding of cash. If it did pay depositors, that would rapidly bloat the cumulative account balances and make the situation even worse. The account balances would grow more rapidly than GDP (they are already doing that in the 10%/4% policy regime and the high interest would accelerate that).

    Suppose in the 10%/4% policy regime and CB cumulative account balances of 250% of GDP, you have to pay people 4% interest to persuade them to hold cash rather than real assets. This is equivalent to an additional deficit of 10% of GDP which is added to the CB accounts annually. Over time, the cumulative account balance of all account holders at the CB would rise to 500% of GDP. With, on average, each economic actor holding 5 years worth of income in his CB account, would 4% interest suffice to restrain spending those account balances?

    Perhaps such a situation could be stable, but it would depend a great deal on whether the interest rate required to persuade people to not spend their account balances rises as the account balances rise. I’m inclined to think that this interest rate would rise, and this would result in a spiral of accelerating short-term interest rates in which the CB account balances increased, as a ratio to GDP, without limit. Eventually this inflation of spendable CB account balances would leak into the real economy and produce uncontrolled inflation.

    This might be an argument for why one cannot dispense with non-spendable reserves (or, nearly equivalently, short term debt
    issued to drain reserves balances.)

    Perhaps there is a grievous flaw in my reflection above, but if not,
    then I don’t think you can have only one “layer” of banking between
    the public fiscal authority and the private sector. The MMT distinction
    between “vertical money” and “horizontal” money may be an important
    element in restraining inflation.

    On the other hand, the “horizontal money” banking functions don’t necessarily have to be private. But it would take a large cadre of dedicated public servants to perform the credit intermediation and underwriting functions currently performed by the for-profit banks (though one must conceded that they haven’t been great at underwriting in recent decades). These functions needs to be performed well whether in a conventional, MMT or MS policy setting.


  20. The federal government would have absolute control over the dollar supply, via spending and interest. If the “spiral” you mention itself became inflationary, the government always could cut spending.

    Many things would change. For instance, private borrowing interest would be paid to the government, where it would disappear (a reverse spiral??).

    I suggest the key to economic growth and inflation prevention is the money supply, which the government would be able to control directly rather than by the currently indirect means.

    Rodger Malcolm Mitchell


  21. Hi Rodger,

    On further reflection, I think that it might be possible to implement your goal of preserving monetary policy even with the current banking system and with very little (perhaps no) structural changes and only a small number of Central Bank policy changes (though one of these changes appears radical).

    I think that the legal or financial structure changes you have mentioned to provide direct government control of interest rates or lending may be unnecessary. It may be possible to preserve CB control of short-term interest rates, contra my prior concerns (which were formulated within the context of present CB reserve requirements policies). The policy changes are (I guess) highly unusual; I have not seen them advocated before, though my familiarity with MMT/MS ideas is small and I may easily have missed this.

    Maybe this is a crazy idea, but within my admittedly limited grasp of functional finance, I don’t immediately see the flaw in it.

    I’d like to recap my prior concerns to preface the further idea.

    As I understand it, Central Banks (using the US Fed as an illustrative example, though the details of monetary operations may differ slightly in other countries) control short term interest rates in the real economy by either open market operations in publicly traded short-term debt instruments or (if there is no public debt, as advocated by some) by manipulating the overnight interbank reserves lending rate. Banks borrow reserves from each other to avoid overdrafts at the CB, which are typically punitively priced. Horizontal cash flows between banks in the real economy are mirrored by corresponding interbank flows in the reserve accounts of banks at the CB (payments clearing) and so banks will not lend in the horizontal economy at less than the rate they pay on their short-term borrowings of reserves. They are not allowed to operate with their CB reserves balance chronically negative, so they are obliged to manage their lending into the real economy in such a way that they can sustain a positive reserves balance over the long term.

    In the policy preferences of progressive-minded MMT advocates, reserves can grow very large, to significant multiples of GDP. In such a situation, if the reserves are not drained through sovereign debt sales, many or most banks would have such large reserves balances at the CB that (under current policies) they would never need to borrow reserves from other banks. Interbank overnight lending would mostly cease, the interbank rate would drop to zero, and the CB would lose its ability to influence short term interest rates in the real economy by charging a penalty rate on overdrafts — almost no-one would ever be in deficit. Under conventional policy regimes, the CB needs bank reserves to be drained (through debt issuance) to a level low enough that a significant number of banks are at risk of being in deficit at any time. This results in the CB penalty rate for overdrafts having some “bite” and leads to a vigorous overnight interbank reserves lending market, with the corresponding effect on short-term rates in the real economy.

    It appears to me that progressive-minded MMT advocates tend to not care whether CB reserves get really large, and they seem to be not too concerned about the limits this places on CB short-term interest rate policy. They allow that the CB could pay a support rate on reserves to reward banks for holding them, though it looks to me as though the banks really don’t have much choice in the matter. It is hard for them to do anything with their reserves if the CB doesn’t pay a support rate. My
    “gut” sense is that it cannot be entirely wholesome that banks have
    large reserves balances that they don’t have any reason to want to have.

    But it seems to me that there is a way that the CB can stimulate interbank lending and recover control of short-term interest rates even in a situation in which there is no public debt issued and bank reserves are a multiple of GDP. It’s a blunt heavy-handed tool, but it might work. The idea would be to make the banks “need” their large reserves balances:

    * set the reserve requirement at a very high level, slightly in excess of the total amount of reserves in the banking system
    * set the support rate to zero
    * set the penalty rate on bank borrowing from the CB at the appropriate level to achieve the desired short-term lower interest rate bound in the real economy

    The first point above would be a radical departure from current reserve requirements, which are a fraction of deposits. If the total bank reserves were a multiple of GDP, this new policy would entail that the reserve requirement be a multiple of deposits, perhaps a significant multiple (factor of 10s, perhaps). I don’t understand functional finance fully, but it seems to me that the level of the reserves requirement is an alternative tool to debt issuance to stimulate interbank lending by creating a situation in which many banks need to borrow reserves at the end of each accounting period.

    A reserve requirement that was a significant multiple of deposits would result in a mismatch between the CB penalty rate and the implied real economy short-term interest rate. A simple thought experiment about what a notional newly incorporated bank would have to do to acquire reserves suggests to me that the penalty rate would need to be set at the desired real economy short-term rate lower bound divided by the multiple of deposits at which the CB set the reserve requirement. If the reserve requirement were 20 X deposits, then a short-term target of 5.0% in the real economy could be achieved with a 0.25% penalty rate.

    Rather than draining reserves from the banking system through debt issuance, the CB could “freeze” them with a very high reserve requirement. By setting the reserve requirement to be higher than the total level of reserves, some banks would always be in deficit and would be obliged to borrow either from the CB or in the interbank reserves market. This would re-establish CB control over short term rates, though with a multiplier.

    The reserve requirement multiple of deposits would probably have to be watched closely, since total bank lending and consequently deposits can fluctuate a great deal over the business cycle.

    There may be significant problems with this idea. It certainly looks outlandish by the standards of historic CB policy. If it is not profoundly flawed (it might be — I am not skilled enough to clearly perceive what the implications might be for international capital flows in a world in which different nations had different deposit multiples; i’m guessing that if there is a big problem, it will be here), it might provide a way of implementing your proposal to preserve the CB policy tool of short-term rates, which would indeed seem to provide more policy space than is available within the policy preferences of most progressive minded MMT advocates. It does not require the radical changes you have suggested in the relationship of the central government to the credit system. I would think that MMT advocates might be open to this idea since it does not reduce the policy space that they want to exploit. They don’t have to employ this tool if they think that it is unnecessary. It might also lower the barriers to MMT/MS ideas among mainstream economists, many of whom believe that short-term rate policy is an indispensable tool of macroeconomic management.


    Sam Conner


  22. We already have a tested and proven cure for stagflation: supply-side economics. Cut taxes, cut regulation, and cut welfare spending. That reduces the cost of inputs to the economy while stimulating both spending and investment. Cut taxes to increase the rewards of work and investment, in turn reducing the cost of capital. Cut regulation to reduce costs. Cut welfare spending so that working is more attractive, leading to increased production.


    1. Cutting taxes ALWAYS is good, simply because the federal government, being Monetarily Sovereign, has no need or use for tax dollars. In fact, all federal tax dollars are destroyed upon receipt. No need to wait for stagflation. Taxes should be cut, today.

      Cutting unnecessary regulations ALWAYS is good because, well, they’re unnecessary. But cutting necessary regulations is bad because, well, they’re necessary. No need to wait for stagflation. Unnecessary regulations should be cut, today.

      Cutting welfare ALWAYS is bad, because it simply punishes the poor at just the time when the poor need more help, not less. The notion of starving the poor so that they will accept the worst possible jobs is mean-spirited and abhorrent.

      Do you believe the poor are just a bunch of lazy takers who would rather accept the crumbs of welfare than work for a living? Do believe the only way you can get the poor to work is to starve their children and apply the lash? Do you really think the poor are intentionally poor?


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